FCG ETF: Upside For Natural Gas Stocks In The Energy Bull Market

Summary

  • The FCG ETF holds a portfolio of energy sector stocks with exposure to natural gas production.
  • The fund has outperformed other energy sector ETFs, benefiting from strong natural gas pricing.
  • We are bullish on the FCG ETF which is a good option to capture the high level trends in the industry.
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The First Trust Natural Gas ETF (NYSEARCA:FCG) invests across a portfolio of companies that derive the majority of their revenues from the exploration and production (E&P) of natural gas. This is a unique exchange-traded fund compared to many more alternatives which focus on oil E&P stocks or natural gas infrastructure and pipeline names. Indeed, the attraction here is the strong momentum in natural gas with prices climbing to the highest levels in the past decade amid tight global supplies as a fallout of pandemic-related disruptions now coinciding with firming demand. Fundamentally, the stocks with direct exposure to natural gas are benefiting from stronger earnings supporting a positive long-term outlook. While FCG has already been a big winner this year, up over 90%, we expect more upside as the bull market in energy is likely to continue through next year.

(Seeking Alpha)

What is the FCG ETF?

The FCG ETF is designed to track the "ISE-Revere Natural Gas Index" as a passively managed investment vehicle. The underlying index here considers U.S. listed companies generating a "substantial portion of their revenues from midstream activities and/or the exploration and production of natural gas" and where natural gas reserves account for 30% or more of their total proved reserves. This is important considering most companies typically produce crude oil as a primary resource while natural gas is released and captured as part of the oil drilling process depending on the type of deposit and extraction technology. By this measure, companies have varying levels of direct exposure to natural gas and related by-products like natural gas liquids which include propane, butane among other hydrocarbons.

Another criteria utilized in the ETF is a minimum market capitalization of $250 million which excludes micro- or nano-cap companies. While 85% of the holdings are based on companies involved with E&P operations, there is also room in the other 15% to include master limited partnerships (MLPs) which include midstream infrastructure and pipeline names. Finally, the fund utilizes a liquidity-adjusted market capitalization weighting methodology and is rebalanced quarterly. The weighting for any individual stock is capped at 4.5%.

Overall, while there is some grey area in terms of classification and overlap between oil E&P and natural gas names, FCG does a good job of capturing the high-level themes with a group of companies well-positioned to benefit from higher natural gas prices.

FCG Holdings

The fund currently holds 40 stocks with the allocations tilted towards mid and small-cap companies. The average market cap of FCG holdings at the last quarter-end was $4.4 billion, with ConocoPhillips (COP) as the largest holding with a 4.5% weighting and a market cap of $89 billion. The top 10 holdings together represent about 41% of the fund which is a relatively good balance compared to other funds that are more concentrated among the top holdings.

(source: First Trust)

Going through the holdings, there may be some confusion because several names are not necessarily recognized as a "pure-play" on natural gas. Again, the weighting methodology is based on the company's market cap and the significance of natural gas within total revenues, and the proportion of proven reserves.

For example, the largest holding in ConocoPhillips has generated $7.9 billion in sales year to date through Q2 from natural gas and natural gas liquids representing 41% of its total revenue. This is in contrast to a company like EQT Corp. (EQT) with a smaller weighting in the fund at 3.3% but primarily a natural gas producer. Here EQT generated a smaller $2.2 billion in sales YTD from natural gas, although that amount comprised nearly 100% of its business. It's up for debate if the fund weighting methodology could be improved, but the point is that every company in FCG is benefiting from the positive pricing trends of natural gas by some measure.

FCG Performance

FCG has had a big year reflecting the strong performance of the broader energy market. The price of natural gas through the Henry Hub gas futures benchmark currently at $5.60 is up over 110% in 2021, outperforming WTI crude oil which has rallied a still-impressive 58% this year. As mentioned, part of the dynamic has been supply-side disruptions going back to the depths of the pandemic in 2020. When prices collapsed between Q1 and Q2 of last year, many of the marginal producers took production offline citing risks to cash flow and the extreme uncertainty. In conjunction with the improving economic outlook and macro conditions from the second half of last year, energy prices began to rally sharply looking ahead at the demand rebound.

(source: finviz.com)

The top holdings within the ETF have all benefited from the trend higher in energy prices. Going back to the discussion of companies that are pure-plays on natural gas vs. the more diversified names, the takeaway from the performance of the underlying stocks is that the range is wide based on company-specific factors but overall positive. Devon Energy Corp. (DVN) is a standout among the top-10 holdings with shares up 134% in 2021 even though the company generates more revenue from crude oil. Some of the smaller holdings have also outperformed.

Chart
Data by YCharts

Recognizing the tilt towards natural gas in FCG, we note that the fund has outperformed several other energy sector and oil & gas industry ETFs. FCG's 93% return this year is above 74% from the Invesco S&P SmallCap Energy ETF (PSCE), 67% in SPDR S&P Oil & Gas E&P ETF (XOP), 42% with Energy Select Sector SPDR (XLE), and 34% from the iShares Global Energy ETF (IXC). That said, there is an understanding here that FCG likely has higher risk compared to some other funds considering the more volatile prices in its natural gas exposure. The profile of the underlying companies in FCG also differs from the large-cap energy leaders in XLE and the more diversified portfolio of the XOP ETF.

Chart
Data by YCharts

FCG Stock Forecast

With a bullish outlook on energy, we believe that natural gas prices can continue to climb higher which will add momentum to the underlying names in the FCG. Without having to pick winners within natural gas stocks, the FCG ETF can benefit from the high-level themes driving the industry.

From a high level, the data we're looking at shows that global production in energy has been slower to recover compared to consumption for all petroleum products. According to the U.S. Energy Information Administration (EIA), global consumption is expected to climb 5.4% this year compared to only a 2.1% increase in production over 2020. In 2022, on a 2-year stacked basis, consumption is forecast to be 9.3% higher from 2020 levels while production continues to trail up a smaller 7.8%. Beyond all the other headlines, this supply and demand dynamic with the market in an effective deficit is a fundamental tailwind for higher oil and gas products.

Global petroleum and other liquids

(Source: EIA)

We also believe that natural gas prices can continue to outperform crude oil to the upside within energy. Beyond the pandemic-related disruptions to production for the sector, natural gas demand has been particularly strong due to some key developments. A spike in regional natural gas prices in Europe to record levels has translated to tight supply chain conditions globally. In Europe, indications are that inventory levels are well below averages with regional disruptions to worsen over the summer. One challenge was a major fire at a Russian gas processing facility limiting imports into Europe. There are also competing trade routes internationally that have shifted the demand mix towards Asia adding to the scarcity.

(source: EIA)

There is a possibility that a colder than normal European winter season could add to the market pricing in the coming months. Our take is that natural gas prices are breaking out into a new and higher normalized pricing environment. Even with the scenario that supply and demand conditions stabilize going forward, the underlying demand growth can also outperform helping to keep the market bid. There is a sense that the post-pandemic global recovery will continue through 2022. Recent data showing declining Covid cases and governments worldwide easing international travel restrictions are bullish for energy.

Final Thoughts

The FCG ETF is a great way to gain strategic or tactical exposure to the bullish trends in the natural gas market. The underlying companies in the fund are benefiting from strong cash flows with the earnings momentum that can send shares higher. The fund itself pays a dividend that currently yields 1.7% based on a variable quarterly payout. The expense ratio for FCG is 0.6% which is in line with other examples of industry-specific ETFs.

We believe the fund can work in the context of a diversified portfolio to overweight energy with the ability to outperform category peers. Several ongoing fundamental tailwinds in the energy sector support continued momentum for the FCG ETF. We are bullish and rate shares as a buy with a price target of $22.50 for the year ahead.

On the downside, a deteriorating macro outlook with a slowdown in global growth would likely limit demand for energy, pressing sentiment and prices lower. We expect natural gas prices to remain volatile, which adds to the potential for wide trading swings in the group and the FCG ETF. Other monitoring points include updates on Europe supply conditions as a key market driver over the coming quarter.

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Disclosure: I/we have a beneficial long position in the shares of FCG, PSCE either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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